Consider These Things Before You Invest in Debt Funds

Consider These Things Before You Invest in Debt Funds

Debt funds are a type of mutual fund that invests a substantial portion of your money in fixed-income instruments like debentures and government securities, corporate bonds, and treasury bills.

Diversifying across securities is a way to maximize returns and generate decent returns. The returns from debt mutual funds are often predictable and therefore suitable for conservative investors. These mutual funds are suitable for both medium- and long-term investors. Medium-term ranges from 3 months to one year. The range of short-term options is from 3 months up to 1 year.

While debt mutual funds are generally considered safer than equity funds because they don't invest directly in market-linked securities they still face certain risks such as credit risk, interest rate risk, and liquidity risk.

Investors need to be aware that there are risks associated with debt mutual funds, particularly after recent defaults and downgrades. Here are some things to keep in mind before you invest in debt mutual fund.

The Expense Ratio

The total expenses incurred to run the debt fund scheme is called the Expense Ratio. Because debt funds have a lower return or upside, the expense ratio is more important than equity mutual funds.

Direct plans should be preferred by investors whose expense ratios are low. After taking into account the expense ratio, investors should calculate the returns from a debt fund. If the return on a debt fund is 9 percent and the expense ratio is 1.5%, the actual return to the investor will be only 7.5%.

The Duration and the Maturity

Interest rate movements are more dangerous for debt mutual funds. There is generally an inverted relationship between bond prices and interest rates. Modified duration simply refers to the price sensitivity of a bond fund to change its interest rate.

This chart shows how interest rates affect the NAV (net asset) of debt funds. The more sensitive a particular debt fund is to interest rate changes, the longer it has been modified.

These funds perform better in a falling interest rate regime while funds with a longer modified duration do well in rising rates. Longer duration funds tend to be more volatile than shorter duration funds.

Both the maturity and the duration of debt funds play an important part.

The Yield To Maturity

Yield to maturity is the expected rate of return for a debt fund if all securities are held until maturity. A debt fund's yield to maturity is 9 percent. If the portfolio is kept constant until all holdings are matured, the investor will receive a return of 9.9%.

If the fund manager is following active management of the portfolio, yield to maturity will not provide a definitive indication about returns.

It is crucial to evaluate the yield to maturity of short-term debt funds with an accrual strategy if you are considering investing in these funds.

The Interest Rate Scheme

The attractiveness of debt funds will be affected by the interest rate regime. A falling interest rate regime will see that previously issued bonds are valued more than newly issued bonds.

If interest rates rise, bonds that were previously issued will lose value. Investors would rather invest in bonds that have a higher rate.

Debt mutual funds invest in bonds and perform well in a falling interest rate environment. Existing bonds in the portfolio will have higher coupon rates, so they are more likely to do well. When selecting a debt mutual fund, you should consider the current interest rate regime as well as other factors.

Portfolio Risks

Debt funds are also subject to credit risk. Credit rating agencies rate debt securities based on their creditworthiness and ability to repay.

Fixed income securities rated AAA are the highest-rated and most likely to have low credit risk. Low credit ratings like 'C' can lead to high default risk.

It is therefore important to verify the credit ratings of all portfolio members of the debt fund. It is a good idea to invest in a portfolio that contains fixed-income securities with high ratings.

Average Maturity of the Fund

A debt fund invests money in different debt instruments with different maturities. These maturities can be used to determine whether the fund will be short-term, medium-term, or long-term.

The weighted average maturity can be calculated by taking into account the maturity period for an asset and the amount of that holding within the total assets. Because they are more likely to hold assets for longer periods of time, funds with a higher average weighted maturity will deliver better returns. Long-duration funds are more susceptible to fluctuations in interest rates. The fund's NAV may fluctuate more, which can lead to higher risk.

Assets under Management

AUM is the market value of mutual funds' investments. To manage their returns and distribute dividends to investors, debt mutual funds heavily rely on their AUM. A debt mutual fund that has a large fund size or manages more assets will be able to spread fixed fund expenses among its investors. Larger funds will result in lower expenses per person. This is reflected by the fund returns.

A larger fund house with more assets or fund size can help negotiate better deals with debt issuers.

To Summerize

Benefits of debt funds include regular income, high liquidity, and predictable returns. Indexation is available to debt funds after three years. This makes them tax-efficient investments. It is obvious that debt mutual funds can be great investments if chosen wisely, taking into account your investment objectives and risk appetite. Also, take into consideration the key factors that directly impact the fund's performance.

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